The Balance Sheet – The lesson of Japan

by Dave

The New Yorker

The lesson of Japan is that a country’s stock market is not going to rise over time if, over time, its companies fail to create economic value for their shareholders. Felix says that “Japanese companies are well-run.” But, in fact, they’re not well run, at least by the standards that are relevant to shareholders—return on equity, profitability, growth, and managing cash flow in a shareholder-friendly way.

What this means is that for much of the past two decades, Japanese companies have been destroying economic value for shareholders, using far more capital than they’re generating.
Japanese firms’ profit growth is also well below what American companies would consider acceptable. And on softer metrics, too, Japanese companies don’t look like good investments: they’re still concentrated in capital-intensive industries, and are surprisingly weak in industries where immense profits can be reaped after small investments, like, most notably, software.

In the 1990s, the average return on equity for the Nikkei was around four per cent, and in the second half of that decade and into the early years of this one it fell below two per cent. (In the U.S., the average R.O.E. is closer to eleven to twelve per cent.) According to this report, between 1998 and 2003, of all large-cap Japanese companies, only eight had an R.O.E. above ten per cent, which is a completely ordinary performance by U.S. standards. And even now, Japan’s average R.O.E. is by far the lowest of any major economy.

None of this is too surprising—historically, Japanese companies have been disdainful of the idea of shareholder value and of traditional profit metrics. In 1998, the chairman of Mitsubishi Heavy Industries famously said, “I openly brag that I don’t cater to shareholders,” and, even more amazingly, “We don’t give a hoot about things like return on equity.” In part, this is because companies’ heavy reliance on debt financing and interlocking relationships meant that they felt they didn’t need shareholders. It’s also because many companies saw themselves as fulfilling a social role.

What the experience of Japan teaches us, in other words, is that when companies are not profitable (in an economic sense), their stocks will not go up. It also teaches us that bubbles exist, and they can lead to assets being crazily overvalued.

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